Zoning's Early Warnings for Investment Impact

By Narendra Srivatsa
Verisk Commerical Real Estate

Every toolbox holds a rusty hammer, the neglected tool that one day promises to come in handy. Hammers may be low-tech, but they‚Äôre difficult to break and highly reliable ‚Äì often just the kind of tool needed in managing commercial real estate investments. In a world of high stakes and complex uncertainties, risks and related losses may not even be on a company‚Äôs horizon at the time of investment. Handy indeed is the implement that can provide a source of reliable information for every transaction.
A zoning report may just be the investor‚Äôs rusty hammer. As a key part of the due diligence process, an attorney usually orders a report purely for compliance purposes and to assess outstanding legal issues. Zoning is likely the lowest-cost piece of information in due diligence ‚Äî but arguably the most valuable. Details drawn from a more insightful use of zoning information can help investors roll with the market‚Äôs dynamic nature. Those insights can even provide an early warning for critical aspects that affect return on investment, and help reveal hidden risks or value.
Commercial real estate investments are all about context and timing. Zoning helps define the property and value at a moment in time and, as such, tends to be viewed as a snapshot, rather than a long-term predictor. Yet that perception vastly undervalues the importance and usefulness of zoning information. A zoning analysis is a leading predictor of value because a zoning change can often signal an approaching market shift or a region‚Äôs growth potential six months or more ahead of time. New zoning rules can change market conditions, create submarkets, and affect areas not subject to the new rules. Understanding the details can potentially help an investor better anticipate risks and opportunities associated with growing markets, saturated markets, and alternative uses. That‚Äôs how advantages in the competitive real estate market are often created.
Clues to Growing Markets
Expansion of commercial zones is frequently a strong indicator of economic growth, often leading to higher employment and a vibrant outlook for an area. For investors in the right property sector, returns can be tremendous. For example, if a large office building comes in as part of a zoning expansion next to a multifamily complex, the complex can likely achieve higher rental income and fill its vacancies. But if a poorly maintained property is located near a new multifamily complex, the rezoning can lead to lower rents for the older units and harm investment.
Zoning reports bring attention to important nuances that result from zoning changes. One scenario involves rezoning around transit-oriented developments (TODs) or WalkUP (walkable urban place) neighborhoods to accommodate the interests of changing demographics (Millennials, baby boomers, retirees aging in place, and so forth) and expand the commercial space to serve them. These can offer new opportunities for businesses to access deeper labor markets that have easy access to their workplaces. Examples of this are becoming common in new submarkets found around the Brooklyn (New York) Navy Yard; in Meriden, Connecticut; and in the walkable neighborhoods around Washington, D.C., that allow accessory dwellings such as an apartment in a house‚Äôs basement or over a garage, corner groceries, and limited retail spaces.
In another iteration, rezoning is opening up fallow land to develop new corporate parks, offices, and multifamily structures. Communities typically announce those changes months ahead of any groundbreaking. Long before a ceremonial shovel hits the dirt, careful analysis of the larger region, current zoning, building stock, and growth patterns can help identify areas where change can be influenced or is in the offing. A great example is Long Island City, New York, which was ignored by commercial real estate developers for decades. After pioneering investors recognized the implications of rezoning, some raked in huge profits when the river views and one-stop subway ride into midtown Manhattan finally attracted new offices and residential high-rise buildings. Those canny investors recognized that undeveloped areas with small single-story buildings and easy accessibility to Manhattan were ripe for rezoning to address sky-high rents across the East River.
Saturated markets, sharp elbows
High-density regions often react in different ways to restrictions on rebuilding. Restrictions can come in the form of height limitations, floor area ratio (FAR) requirements for public spaces, and setback considerations that can reduce rentable square footage and the subsequent rental income. There‚Äôs no question that properties have lost significant double-digit percentages of rentable space in such situations. The changes can kick in even when only a certain portion of the building is altered, as in limitations in central business districts (CBDs) such as Manhattan. Such provisions may effectively restrict common improvements and upgrades in the property, typically resulting in lower rental income and space now unadaptable to a changing demographic, as in the Georgetown area of Washington, D.C., where controversial height restrictions cap most buildings at 130 feet.
One paradox facing investors is that changing markets remain a constant. Zoning overlays acknowledge and often encourage change by allowing alternative uses for properties. These overlays can very often be done by the local government without state involvement. An investor that is able to rapidly transform a low-rise office building into a retail center without hassles from zoning regulations will likely gain a strong advantage in the marketplace. It‚Äôs well understood that zoning laws limiting these changes will probably slow redevelopment and result in higher legal hurdles and increased cost of ownership. Following this dismal scenario, the investment could end up being the wrong property in the wrong place and at the wrong time. An example of this emerged when the Rochester International Airport in Minnesota increased its runway safety zone through a modified zoning ordinance. Surrounding properties lost development potential while their owners witnessed a loss in value.
So, what tools do you have in your box? An accurate zoning analysis is essential in forecasting a property‚Äôs future restrictions, uses, and potential. In a world of crashing economies, shifting demographics, rampant litigation, and geopolitical issues, zoning is the dependable tool that is needed to uncover hidden value and risks. An investor‚Äôs toolbox may contain any number of sophisticated gadgets, but even the most complicated projects can benefit from a zoning report ‚Äî the hammer that can help nail an investment objective with greater certainty.